Play China With This Small-Cap ETF

Editor's note: Don Dion is the president and chief investment officer of Dion Money Management and the publisher of the Fidelity Independent Adviser family of newsletters. He provides commentary on the financial markets, with a specific emphasis on exchange-traded funds and mutual funds to his clients and subscribers. He welcomes your comments at don.dion@dionmm.com.

China is arguably the most popular emerging market today. A tremendous bull run lifted iShares FTSE/Xinhua China 25 ( FXI) more than 300% from 2005 to 2007, and many investors piled into all manner of Chinese stocks.

Though investors appear partial to technology stocks such as Baidu ( BIDU) or Suntech Power ( STP), these are often a small allocation in Chinese ETFs, if they are present at all. Too many ETF investors have stuck with the large-cap FXI, to the detriment of their returns.

While there are several different iterations of the broad China ETF, such as PowerShares Golden Dragon Halter USX China ( PGJ) and SPDR S&P China ( GXC), only one ETF offers investors a serious shot at outperformance -- Claymore Alpha Shares China Small Cap ( HAO). Rather than first point out the strengths of HAO, however, I'll explain why FXI and its close cousins are not the place to put your money.

Generally speaking, it is common knowledge that market-based economies are more efficient and produce greater wealth for the population than socialist and other economic systems. The main trend responsible for making China wealthy has been the move away from socialism and toward greater freedom in the economic life of its citizens. Socialism persists within the economy, however, in the form of state-owned enterprises.

In a December article for my monthly ETF Report, I wrote: In the long run, China's insistence on maintaining state control of certain industries should lead to equity underperformance as profits are sacrificed for market share or political and social stability (we've already seen the oil companies lose profits due to gasoline price controls).

We saw it again with electricity prices. On June 9 of this year, China's biggest power companies asked the government to allow them to increase prices after they lost money in 2008. Two of the companies -- Huaneng and Datang -- are holdings in FXI and other China ETFs.

The degree to which these firms sacrifice efficiency was the question answered in a paper by two economists for the Hong Kong Institute for Monetary Research. Giovanni Ferri and Li-Gang Liu found that state-owned company profits are the result of below-market credit rates, and if state-owned enterprises (SOEs) were forced to pay market rates, their profits would vanish.

They also detail how the majority of bank loans go to SOEs, even though they represent only a quarter of GDP. Chinese technocrats are not blind to these statistics and the country has said it would accelerate, rather than slow, market reforms in the face of the global crisis. China still has low-hanging fruit because it can generate growth by shifting credit and regulation in favor of the more efficient private sector, but at best, the SOEs advantage remains constant. More likely, the government will level the playing field with private firms.

Luckily, there's an ETF that offers a way to invest in those private firms-- Claymore/Delta China Small Cap ( HAO), which mainly invests in H-shares along with a sprinkling of ADRs. The sector weightings tell the difference: HAO has a smaller allocation in financials than any fund but PowerShares Golden Dragon Halter USX China ( PGJ) and a smaller allocation in telecommunications than all the other ETFs. HAO's largest weights are in industrials, materials, consumer services, and consumer staples.

Its top 15 holdings also clearly show the difference. While 76% of FXI's assets are in its top 15 holdings, iShares FTSE China ( FCHI) and SPDR S&P China ( GXC) allocate 64% and 55%, respectively, to the same stocks. PGJ holds 27% of assets in those stocks as well, but HAO holds none of them.

PGJ represents the second-best choice, due to its heavy allocation in technology stocks such as Baidu, Netease ( NTES) and Shanda ( SNDA).

Although HAO does not hold Baidu, it does hold tech stocks and even offers exposure to several tech firms without ADRs. However, along with PGJ's innovative technology holdings, one must also hold the SOEs. A better way to overweight China technology shares would be to hold HAO and add small single-stock holdings in favored tech names.

All China funds remain closely correlated, but HAO and PGJ have broken away from the pack in 2009. The three ETFs with large SOE holdings are up about 40%, compared to 50% in PGJ and 60% in HAO. These ETFs will separate further as investors learn to distinguish between Chinese companies.

At the time of publication, Dion was long PGJ.

Don Dion is the publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

Dion is also president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

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